Features of commercial credit applications
Additional features of commercial applications include, for example, time-varying default barriers, continuous monitoring of the default threshold, the use of alternative option pricing models and different assumptions for the behavior of asset values. They typically incorporate short-term and long-term liabilities, convertible debt, preferred equity and common equity, although this substantially enhances complexity of the model. Hence, structural models are well suited for handling different securities of the same issuer, including bonds of various seniorities and convertible bonds. Even the behavior of the company’s management can be incorporated into a structural model. A typical example is a “target leverage” model, in which the initial capital structure can be adjusted. The level of debt fluctuates over time depending on changes in the firm’s value, so that the ratio of debt to assets is mean-reverting. Nevertheless, it is hard to model a firm that is close to its default threshold, since management often chooses to adjust the capital structure in this situation. Over one-year horizons, however, commercial implementations of structural models have a consistently good track record with respect to the prediction of defaults.
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